Insights


5 European Sectors to Meet Your Investment Challenges

Investors could face a variety of challenges as we head toward the end of the year. Given that there is no one-size-fits-all solution, we believe sectors can be used selectively to address specific issues, such as inflation, tapering and portfolio quality. Within sectors, we currently favour Europe versus the US or global exposures. 

Equity ETF Strategist

Solving for specific issues

Virtually all investors want higher returns and minimised risk, but the way to achieve these goals over the last four months of 2021 seems more complicated than ever. Currently, it does not feel as simple as growth versus value or cyclical versus defensive given the many concerns we face in this near post-COVID world.

One way to approach markets is to consider the biggest issues facing investors and solve for those that are most pertinent to your outlook, portfolio or required returns. 

We’re all watching the data. Just as investors are watching the pace of economic recovery and inflation, so are Jerome Powell and company in order to determine the pace of reducing asset purchases. This gives economic figures great importance to markets and provides a role for sector investing. Sectors offer a historically proven way to target different macroeconomic scenarios.

Picking up the baton with Europe

We favour Europe, particularly compared with the US. Europe has been slower to reopen, suggesting more recovery to come, and the region has monetary stimulus provided by central banks and fiscal plans, including the EU Recovery fund, to provide substantial support. The ECB meeting last week confidently raised the forecast for eurozone GDP growth for 2021 to 5%.1 With a discount rating of approximately 15% to MSCI ACWI and double that to the S&P 500, as well as relatively attractive dividend yields, we believe there is a valuation argument for MSCI Europe as well.

Let’s consider the big issues and potential solutions within European sectors.

Inflation: Materials

Transitory pressures or not, the current inflationary phase is lasting longer than most commentators expected and investors who want to benefit could look to Materials. European Materials is 33% weighted to mining stocks, producers of industrial metals that form a large part of the commodities complex, which has seen a spike this year.

Key to these companies passing on price increases is supply and, thus far, companies appear to be disciplined with capital expenditure plans, not adding to new mining capacity. Even with an increase, such facilities can take many years to come online, leaving a tight demand/supply balance for some time. Commodities, such as copper, continue to be in high demand for building and construction, fulfilling projects enabled by fiscal spending, and meeting newer green markets such as electric vehicles.

Looking at State Street proprietary institutional flows data, we have seen buying across Materials companies (miners, chemical producers and construction material suppliers) in recent months. While consumer strength has driven robust volumes for packaging and specialty chemicals for consumer products, recovering industrial production (as measured by Markit PMIs) has boosted demand for many raw materials.

Tapering: Financials 

Much has been said about when tapering may start, but less about how to solve for it. While the Federal Reserve has grabbed headlines, it is also an issue for the ECB and Bank of England. The policies of all these central banks will matter to financial companies in Europe. Reducing quantitative easing is the first step toward policy normalisation. Inevitably, as soon as the tapering of bond purchases starts, the market will then focus on when the first base rate rise will be. Strengthening bond yields and any steepening of yield curves would be beneficial to banks, feeding through to their borrowing and lending rates, which dictate net interest margins. 

Banks constitute 45% of Europe Financials, and even more if the banking operations of investment banks are included. Life and general insurers (insurance has a 31% weight) could also benefit from higher returns on higher bond yields. Meanwhile, the health of financial markets has been helpful to many insurance providers as well as the exchanges and financial services companies that make up the rest of the sector.

Another theme for the rest of 2021 is likely to be dividends and share buybacks. Distributions from European banks were restricted during the worst of the COVID crisis and the return of share buybacks and dividend increases would be warmly welcomed by investors.

Quality: Health Care

The Health Care sector could offer a degree of quality to investor portfolios or provide lower volatility or defensive growth. The sector has all of these characteristics by virtue of its products and services, increasingly demanded by a growing, ageing and more prosperous global population. The quality tag can be seen in high returns on capital, healthy cash flow and stability of earnings.

For those looking for a comfortable mid-cycle investment, pharmaceutical and biotech companies and their suppliers tend to be less sensitive to rising interest rates. While the COVID pandemic provided significant upside for companies with successful testing and vaccine solutions, there is also a reopening theme for providers who were hit by cancelled medical operations and doctor visits. Meanwhile, given the virus continues to spread, testing, antibody therapies and booster vaccines are all likely to be in demand. Meanwhile, mRNA technology has emerged as a key area for innovation.

US political interference to drug pricing, more regulation and anti-trust enforcement remain, but they appear to be low on president Biden’s agenda compared with COVID and stimulus plans. Nevertheless, we prefer Europe for lower exposure to US political risk.

Diversification: Real Estate

Most investors we’ve spoken to recently want to stay invested in equities but would also like to reduce their risks. One way to do this is to diversify by asset class, geographic income and sector drivers.* Real estate is often used as an alternative asset as it is driven by different economic dynamics and has a relatively low correlation with equities. Accessing real estate via a fund of REITs and property companies, which span an array of industries, provides diversification in another way.

This year, European real estate has seen a merger between the two largest quoted stocks, creating a powerhouse in the German residential market. Other holdings within the sector are well placed for the reopening trends in retail, offices and other commercial operations.

Real estate ownership aims to provide natural protection against inflation. Real estate rents and values tend to increase when prices rise, with many leases tied to inflation. This supports cash flow and thus dividend growth, providing a reliable stream of income even during inflationary periods. 

Readers familiar with our institutional flows analysis available in the latest monthly update to the Sector & Equity Compass will know that Real Estate stands out as the sector with the most extreme underweight positioning.

Contrarian Opportunity: Energy

Most investors accept that the potential for higher returns comes with higher risk, and Energy is a case in point. The European sector was a top performer in Q1 2021, made a sharp turn in Q2 and has (until recently) been the bottom performer this quarter to date. During the recent period of underperformance, earnings forecasts have continued to rise in response to higher crude oil prices this year and a still-restricted supply response, leaving the sector significantly derated.

From here, the sector can help those looking for positive sensitivity to inflation, strong earnings sentiment and extreme valuation lows. Energy is widely used to position an economic outlook and was an important part of the reflation trade earlier in 2021; there are signs this trade could return. Energy ETFs saw the highest level of net inflows among European sector ETFs last month as well as year to date.

As with the Real Estate and Health Care sectors, Energy is also a large underweight position on average across institutional investor portfolios. For Energy, a large part of its unpopularity is its responsibility for carbon emissions and the necessity to reduce them and consider climate change. European oil and gas companies have been quicker to respond than their international counterparts. We are a long way from acknowledgment of climate change by major players to transition, but the majors have the technical knowledge, logistical and geographic reach to help deliver solutions needed to help affect change.

How to Play these Themes

Investors who are interested in playing the themes described above can do so with SPDR ETFs. To learn more about these funds, and to view full performance histories, please follow the links below. 

SPDR MSCI Europe Materials UCITS ETF

SPDR MSCI Europe Financials UCITS ETF

SPDR MSCI Europe Health Care UCITS ETF

SPDR FTSE EPRA Europe ex UK Real Estate UCITS ETF

SPDR MSCI Europe Energy UCITS ETF

TER reduction for SPDR MSCI Europe sector range

As of 13 September 2021, we have reduced the TER on our 10 MSCI Europe sector ETFs from 0.23% to 0.18%. 

 

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